Importance of the differences between the direct and indirect method

Possibly the most important financial report a company can present is the cash flow statement. One reason this statement is of paramount importance is that it can be used to assess the overall health of the company, with relevant information included from both the company’s balance sheet and income statement. This statement is particularly important for investors, who can use it as a performance indicator and determine the possible future prospects of the company. The statement of cash flows was introduced in 1987 by the Financial Accounting Standards Board (FASB – SFAS 95) to replace the statement of changes in financial position. This change was the FASB’s failed attempt to get management to use the direct reporting method instead of the indirect method, which is still very popular today.

The direct method, which can also be referred to as the income statement method, uses cash income and expenses to report its business activities. The direct method is the SEC’s preferred method, but it is not mandatory for companies to use it in their reporting. The only real difference between the direct and indirect methods is found in the entity’s presentation of the operational portion of the financial statements. The only difference is that; In the direct method, operating cash payments are subtracted from operating cash income to arrive at net cash flow from operating activities. Some proponents of the direct method argue that it provides a better representation of a company’s ability to sustain cash flows from operations, as opposed to investing and financing. As a result, companies that are better able to generate cash from operations can more easily pay off their debt. The presentation of information using the direct method suggests that net cash flow from operations is better as it is presented on a cash basis.

In contrast, the indirect method, also known as the reconciliation method, shows net income with adjustments that convert it to net cash flow from operating activities. While the direct method requires a reconciliation of net income to cash from operations, the indirect method provides this reconciliation automatically. Almost every corporation prepares the cash flow statement using the indirect method when preparing their annual financial statements. Many argue that this method is preferred by most companies because it is straightforward and easy to understand. Others claim that this method allows for better linking of information between a company’s financial statements.

The cash flow statement consists of three sections: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. These sections break down a company’s sources and uses of cash into easily identifiable and relevant information that investors often rely on to assess financial stability and strength. A company with strong cash flow from operations shows it is in a good position to continue and potentially grow its business. Companies with higher cash flows from investing or financing activities show weakness and the possibility of future failure.

The cash flow from operating activities section of the statement of cash flows shows the cash inflows and outflows of current assets and current liabilities of a company. The inflows and outflows from this section can be determined by examining the income statement for the period. Cash flows from investing activities can be identified as non-current assets, generally non-current assets such as property, plant and equipment. Finally, the cash inflows and outflows reported in the financing activities section include long-term debt and equity.

The presentation of financial statements has been shown to help management make decisions, and cash flow information is an important factor in making those decisions. Therefore, the debate between the direct and the indirect method must be considered. The SEC believes that the direct method provides more meaningful information because it breaks down key cash inflows and outflows. Proponents of the indirect method argue that the only reason the Financial Accounting Standards Board (FASB) issued SFAS 95 was to force companies to distinguish the differences between net income and cash inflows and outflows. Additionally, the indirect method is far less complex since for a larger company the direct method is essentially like going through all of your bank statements.

According to an October 2010 article by Salome Tinker on the Association for Financial Professionals website, the FASB and the International Accounting Standards Board (IASB) have worked together to redefine how companies present their financial performance. One of the most discussed topics during the meetings of these two boards related to the direct vs. indirect method of cash flow accounting. Both Boards concluded that when finalized, the direct method will be the only acceptable method for entities to report their cash flow statements. They want a worldwide standardization of the format that makes it easier to maintain the direct method. Since the majority of companies report using the indirect method, this news can be very important as changing methods can be costly.